Nov 11 2010

Okay, a trade deficit is bad, what can we do about it?

In my last post, I outlined the consequences of a nation running a persistent deficit in its current account. In the post below, I will share some thoughts on how a nations can reduce its trade deficit by promoting increased competitiveness in the global economy through the use of expansionary supply-side policies. Earlier in the chapter from which this post is taken, I outlined other deficit reduction strategies, including the use of protectionism, currency devaluation and contractionary demand-side fiscal and monetary policies. In my opinion, each of these methods creates more harm than good for a nation, resulting in a misallocation of society’s scarce resources (in the case of protectionism) and negative effects on output and employment (in the case of contractionary demand-side policies)

Therefore, the following presents the “supply-side” strategies for reducing a deficit in a nation’s current account.

From Chapter 22 of my upcoming textbook: Pearson Baccalaureate Economics

Contractionary fiscal and monetary policies will surely reduce overall demand in an economy and thereby help reduce a current account deficit. But the costs of such policies most likely outweigh the benefits, as domestic employment, output and economic growth suffer due to reduced spending on the nation’s goods and services. A better option for governments worried about their trade deficit is to pursue supply-side policies that increase the competitiveness of domestic producers in the global economy.

In the long-run, the best way for a nation to reduce a current account deficit is to allocate its scarce resources towards the economic activities in which it can most effectively compete in the global economy. In an environment of increasingly free trade between nations, countries like the United States and those of Western Europe will inevitably continue to confront structural shifts in their economies that at first seem devastating, but upon closer inspection will prove to be inexorable.

The auto industry in the United States has been forever changed due to competition from Japan. The textile industry in Europe has long passed its apex of production experienced decades past, and the UK consumer will never again buy a television or computer monitor made in the British Isles. The reality is, much of the world’s manufactured goods can be and should be made more cheaply and efficiently in Asia and Latin America than they could ever be produced in the US or Europe.

The question Europe and the United States should be asking, therefore, is not “how can we get back what we have lost and restore balance in our current account”, but, “what can we provide the world with that no one else can?” By focusing their resources towards providing the goods and services that no Asian or Latin American competitor is capable of providing, the deficit countries of the world should be able to reduce their current account deficits and at the same time stimulate aggregate demand at home, while increasing the productivity of the nation’s resources and promoting long-run economic growth.

Sure, you say, that all sounds great, but how can they achieve this? This is where supply-side policies come in. Smart supply-side policies mean more than tax cuts for corporations and subsidies to domestic producers. Smart supply-side policies that will promote more balanced global trade and long-run economic growth include:

  • Investments in education and health care: Nothing makes a nation more competitive in the global economy than a highly educated and healthy work force. Exports from Europe and the US will lie ever increasingly in the high skilled service sector and less and less in the manufacturing sector; therefore, highly educated and skilled workers are needed for future economic growth and global competitiveness, particularly in scientific fields such as engineering, medicine, finance, economics and business.
  • Public funding for scientific research and development: Exports from the US and Europe have increasingly depended on scientific innovation new technologies. Copyright and patent protection assure that scientific breakthroughs achieved in one country will allow for a period of time over which only that country will enjoy the sales of exports in the new field. Green energy, nano-technology, bio-medical research; these are the field that require sustained commitments from the government sector for dependable funding.
  • Investments in modern transportation and communication infrastructure: To remain competitive in the global economy, the countries of Europe and North America must assure that domestic firms have at their disposal the most modern and efficient transportation and communication infrastructure available. High speed rail, well-maintained inter-state or international highways, modern port facilities, high-speed internet and telecommunications; these investments allow for lower costs of production and more productive capital and labor, making countries goods more competitive in the global marketplace.

Reducing a current account deficit will have many benefits for a nation like the United States, Spain, the UK or Australia. A stronger currency will assure price stability, low interest rates will allow for economic growth, and perhaps most importantly, less taxpayer money will have to be paid in interest to foreign creditors. Governments and central banks may go about reducing a current account deficit in many ways: exchange rate controls, protectionism, contractionary monetary and fiscal policies, or supply-side policies may all be implemented to restore balance in the current account. Only one of these options will promote long-run economic growth and increase the efficiency with which a nation employs its scarce factors of production.

Supply-side policies are clearly the most efficient and economically justifiable method for correcting a current account deficit. Unfortunately, they are also the least politically popular, since the benefits of such policies are not realized in the short-run, but take years, maybe decades, to accrue. For this reason, we see time and time again governments turning to protectionism in response to rising trade deficits.

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

4 responses so far

4 Responses to “Okay, a trade deficit is bad, what can we do about it?”

  1. Blair T.on 15 Nov 2010 at 2:09 am

    After I read this I do admit I was a bit shocked that there was what could be seen as a loophole to our problems. But when you look more into it, it more seems like common sense, which some of it is. I thought it would only seem plausible that a country would want to focus on the goods it does best, it's surprising to think that a country might not think like that. But I guess I was wondering when you're considering the goods that a country makes best would you include food? Because I mean when you think about it some food can be grown everywhere, while some can only thrive in specific locations. I guess I was more curious to if that was included in our list of things that we produce that is superior to others. The next thing I was wondering about would be the investment in education and health care, that you addressed. So if our country would be better off, in a sense, with better healthcare which would lead to healthier people. Why is congress and people in America so opposed to the idea of universal health care? I mean I know it would cost them money, but wouldn't it make them more successful in the end? It just seems like time and time again we're presented with answers to our problems and we don't ever seem to draw to a conclusion. However, I am more curious to know what characteristics a bad- supply policy might be made up of. I can see how a smart supply policy might be ineffective or seen ineffective, because if you only make the one good or goods your the best at then you become dependent on other countries for the good the produce, and that doesn't seem like that could always be the best think. Just like in life where you depend on another person, whether it's to pick up the kids or do the laundry, once you become dependent on them you eliminate what they are doing from your mind. Now I think if we did that with an economy that might not turn out so great because, our domestic goods as well as are own country's economy wouldn't be very well rounded in their skills or the things we produce, and if anything ever happened to the person we depended on than we would be in trouble.

  2. Kevin V.on 05 Jan 2011 at 12:19 am

    When it comes to investing in certain areas such as education, scientific research and development, and public infrastructure, it seems that there is not enough of it to further enhance the economy. People tend to avoid these investments simply because the return in financial value is pretty slim to them personally. However, these investments would bring about drastic improvement in the long run with the economy by providing well-educated workers, better products and constant research, and a better infrastructure that will move products, people, and goods faster than today. Domestic goods production would increase after these investments have played their role.

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    Okay, a trade deficit is bad, what can we do about it? | Economics in Plain English

  4. Vice president Bidenon 28 Nov 2014 at 1:51 pm

    Vice president Biden

    Okay, a trade deficit is bad, what can we do about it? | Economics in Plain English